The recent presidential election, combined with Republican control of both houses of Congress, is widely expected to lead to substantial tax reform in 2017 and beyond. High-income earners who are planning to make significant charitable gifts in the near future may be able to maximize the value of their charitable donations by making such gifts before year-end 2016.
Although several competing tax-reform plans have been proposed (most notably, one by President-elect Donald Trump and another by House Speaker Paul Ryan) and much uncertainty remains, there are some commonalities to be found among the proposed reform initiatives. As you begin your year-end tax and philanthropic planning, consider the following:
- Personal income tax rates on ordinary income are expected to be compressed from the current seven brackets to a simplified three bracket structure. At the same time, the highest marginal income tax rate is expected to decline from the current 39.6 percent to a proposed 33 percent. As a result, a reduction in the highest marginal tax rate would reduce the after-tax benefit of the charitable tax deduction, especially for donors in the highest tax brackets.
- Itemized deductions are anticipated to be significantly restricted under the proposed tax-reform plans. For example, President-elect Trump has proposed limiting the amount of allowable itemized deductions to $100,000 for individual filers and $200,000 for joint filers. House Speaker Ryan has proposed eliminating all itemized deductions except for deductions for mortgage interest and charitable contributions. As a result, caps on itemized deductions would limit the deductibility of charitable gifts, especially for donors who seek to make large upfront charitable gifts to reduce income taxes in years in which they experience a significant spike in taxable income (for example, from the sale of a business, vesting and/or exercises of employer equity grants, receipt of large commissions, bonuses, or deferred compensation).
- Personal income tax rates on investment income may also be reduced. President-elect Trump has proposed repealing the Affordable Care Act, including the current 3.8 percent Medicare surtax imposed on net investment income. In addition, under the Trump plan, the top rate for long-term capital gains and qualified dividends would remain at 20 percent while the brackets for capital gains would be re-aligned with the simplified three brackets for ordinary income. Under the Ryan plan, the current capital gains rate structure would be replaced with a 50 percent exclusion on capital gains, dividends, and interest income, which would effectively tax investment income at half of the marginal rates for ordinary income. As a result, donors who are looking to fund charitable gifts with appreciated securities to avoid recognizing taxes on capital gains may find the tax savings to be more valuable in 2016 than in future years.
- The alternative minimum tax (AMT) would be repealed under both the Trump and Ryan tax plans.
In light of the likelihood for tax reform in 2017, taxpayers might consider accelerating tax deductions to 2016 while deferring taxable income to 2017 to the extent possible. In particular, affluent donors who are contemplating making large charitable contributions within the next several years might consider making a larger, upfront charitable contribution before year-end 2016. Donors seeking to benefit from the higher after-tax value of charitable contributions before year-end, but who have not yet decided which charities should receive their charitable gifts, might consider contributing to a donor advised fund (DAF). (Please note that some taxpayers who are currently subject to the AMT, which would be repealed under both the Trump and Ryan tax plans, may find that their marginal tax rates will be higher in 2017 than in 2016; such taxpayers may be better off doing the opposite: accelerating income to 2016 while deferring deductions until 2017.)
Michael and Megan, a married couple, are currently in the highest marginal tax bracket for 2016 and anticipate that their income in future years will continue to place them in the highest tax brackets in 2017 and beyond. They have a passion for philanthropy within their local community and have earmarked $600,000 of highly appreciated stock (with a tax basis of only $100,000) in their taxable investment portfolio to give to a variety of local public charities. Prior to the election, they were planning to donate the shares to charity in annual installments over the next three years. However, in light of the election and proposed tax reform, they revisit their philanthropic plan with their financial and tax advisors and are now considering gifting the entire $600,000 of appreciated stock to a donor-advised fund before year-end 2016.
Their accountant informs them that their charitable deduction in 2016 would be limited to 30 percent of their adjusted gross income (AGI) when they donate non-cash assets (such as appreciated stock) to a public charity or to a donor advised fund. With an AGI of $2 million and itemized deductions of $100,000 (not including the contemplated charitable gift), Michael and Megan would be able to take a maximum charitable tax deduction of $600,000 (30 percent times $2 million) in 2016. The charitable deduction would save approximately $237,600 ($600,000 times 39.6 percent) in federal income taxes (plus potential state income tax savings). In addition, Michael and Megan would avoid recognizing capital gains on the highly-appreciated shares, which, assuming an effective federal capital gains rate of 23.8 percent (20 percent federal capital gains rate plus 3.8 percent Medicare surtax) and a $100,000 basis in the shares, translates to an additional $119,000 of federal tax savings (plus potential state tax savings). As a result, Michael and Megan’s $600,000 charitable gift could save them approximately $356,600 in federal income taxes in 2016.
In comparison, the same charitable gift could result in less tax savings under the proposed tax-reform plans. For example, Michael and Megan might find that their charitable deduction could be limited to $100,000 per year in 2017, resulting in potential 2017 federal income tax savings of only $33,000 ($200,000 proposed limit on itemized deductions for joint filers less $100,000 “normal” itemized deductions for Michael and Megan times 33 percent proposed top federal rate. In addition, their tax savings from avoiding the recognition of capital gains on the highly-appreciated shares might only be $100,000 – or even less under the Ryan plan (calculation: $500,000 capital gain times 20 percent top federal capital gains rate, assuming elimination of the 3.8 percent Medicare surtax) plus potential state tax savings. As a result, Michael and Megan’s $600,000 charitable gift might only save them approximately $133,000 in federal income taxes in 2017 under Trump’s proposed tax-reform plan (versus $356,600 federal tax savings under the current tax law in 2016).
Putting it all together
Affluent donors who are planning to make sizeable charitable gifts in the next few years may be able to realize greater tax savings by completing their charitable gifts before the arrival of potential tax reform next year. Keep in mind that much uncertainty remains and the resulting tax legislation may be significantly different than the proposed tax plans discussed above. Therefore, it is important to be cautious when planning in advance of new tax legislation. We recommend that you consult your financial and tax advisers to determine whether accelerating your charitable gifts before year-end 2016 makes sense for your specific philanthropic goals and financial situation.